advanced financial accounting 7e (baker lembre king).chap003

8/7/2019 Advanced Financial Accounting 7e (Baker Lembre King).Chap003

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McGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc. All rights reserved.

3

The Reporting Entity and Consolidated Financial Statements


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Consolidated Financial Statements

Many corporations are composed ofnumerous separate companies and,in turn, prepare consolidated financialstatements.


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Consolidated financial statements present thefinancial position and results of operations fora parent (controlling entity) and one or moresubsidiaries (controlled entities) as if theindividual entities actually were a single

company or entity.


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Consolidation is required when a corporationowns a majority of another corporationsoutstanding common stock.


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The accounting principles applied in thepreparation of the consolidated financialstatements are the same accountingprinciples applied in preparing separate-

company financial statements.


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Two companies are considered to berelated companies when one controlsthe other company.


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Consolidated financial statements aregenerally considered to be more usefulthan the separate financial statementsof the individual companies when the

companies are related.


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Whether the subsidiary is acquired orcreated, each individual company maintainsits own accounting records, but consolidatedfinancial statements are needed to presentthe companies together as a single economic

entity for general-purpose financial reporting.


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Two companies are considered to be relatedor affiliate companies when one controls theother or both are under the common controlof another entity.


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Benefits

Consolidated financial statements arepresented primarily for those parties having a

long-run interest in the parent company,including the parents shareholders, creditorsor other resource providers.


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Benefits

Consolidated financial statements oftenprovide the only means of obtaining a clear

picture of the total resources of the combinedentity that are under the parent's control.


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Limitations

While consolidated financial statements areuseful, their limitations also must be kept inmind.

Some information is lost any time data sets

are aggregated; this is particularly true whenthe information involves an aggregationacross companies that have substantiallydifferent operating characteristics.


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Subsidiary Financial Statements

Because subsidiaries are legally separatefrom their parents, the creditors andstockholders of a subsidiary generally haveno claim on the parent, and the stockholders

of the subsidiary do not share in the profits ofthe parent.


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Subsidiary Financial Statements

Therefore, consolidated financial statementsusually are of little use to those interested inobtaining information about the assets,capital, or income of individual subsidiaries.


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The Tradition View of Control

The professional guidance regardingconsolidated financial statements is provided

in ARB 51 and FASB 94.

Under current standards, consolidated

financial statements must be prepared if onecorporation owns a majority of anothercorporations outstanding common stock.


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The Tradition View of Control

ARB 51 indicates that consolidated financialstatements normally are appropriate for a

group of companies when one company hasa controlling financial interest in the othercompanies.


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Less Than Majority Ownership

Although majority ownership is the mostcommon means of acquiring control, a

company may be able to direct the operatingand financing policies of another with lessthan majority ownership, such as when the

remainder of the stock is widely held.


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Less Than Majority Ownership

FASB 94 does not preclude consolidationwith less than majority ownership, but such

consolidations have seldom been found inpractice.


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Indirect Control

The traditional view of control includesboth direct and indirect control.

Direct control typically occurs when onecompany owns a majority of anothercompanys common stock.


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Indirect Control

Indirect control (or pyramiding) occurs

when a companys common stock isowned by one or more other companiesthat are all under common control.


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Ability to Exercise Control

Under certain circumstances, the majoritystockholders of a subsidiary may not be able to

exercise control even though they hold morethan 50 percent of its outstanding voting stock.Examples:

Subsidiary is in legal reorganization or

bankruptcy

Foreign country restricts remittance ofsubsidiary profits to domestic parent company


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Ability to Exercise Control

When consolidation is not appropriate,the unconsolidated subsidiary is reported

as an intercorporate investment.


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Differences in Fiscal Periods

A difference in the fiscal periods of a parentand subsidiary should not preclude

consolidation of that subsidiary.

Often the fiscal period of the subsidiary, ifdifferent from the parents, is changed to

coincide with that of the parent.


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Differences in Fiscal Periods

Another alternative is to adjust the financialstatement data of the subsidiary each period

to place the data on a basis consistent withthe fiscal period of the parent.


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Differences in Accounting Methods

A difference in accounting methods betweena parent and its subsidiary generally should

have no effect on the decision to consolidatethat subsidiary.

In any event, adequate disclosure of thevarious accounting methods used must begiven in the notes to the financial statements.


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Reporting Entity-A Changing Concept

The FASB is currently considering some ofthe difficult issues relating to control.

Ultimately, the FASB is expected to movebeyond the traditional concept of legal controlbased on majority ownership and also require

consolidation of entities under the effectivecontrol of another entity, even though theother entity may not hold majority ownership.


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Reporting Entity-A Changing Concept

This broader view would contribute to theharmonization of accounting standards in the

global economy.


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Inadequate Standards

Consolidation standards relating to partnershipsor other types of entities (such as trusts) have

been virtually nonexistent.

Even corporate consolidation standards have

not been adequate in situations where otherrelationships such as guarantees and operatingagreements overshadow the lack of a significantownership element.


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Although many companies have used specialentities for legitimate purposes, companies

such as Enron took advantage of the lack ofstandards to avoid reporting debt or losses byhiding them in special entities that were not

consolidated.


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Only in the past few years have consolidationstandards for these special entities started to

provide some uniformity in the financialreporting for corporations havingrelationships with such entities.


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Special Purpose/Variable Interest

Entities

Special-purpose entities (SPEs) arecorporations, trusts, or partnerships created

for a single specified purpose.

They have no substantive operations and areused only for financing purposes.


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Special Purpose/Variable Interest

Entities

Special-purpose entities have been used forseveral decades for asset securitization, risksharing, and to take advantage of taxstatutes.


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Special-Purpose Entities

In general, FASB 140 states that SPEs bedemonstrably distinct from the transferor,

its activities be significantly limited, and ithold only certain types of financial assets.


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Special-Purpose Entities

If the conditions ofFASB 140 are met, thistype of SPE is not consolidated by thetransferor of assets to the SPE.


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Variable Interest Entities

A variable interest entity is a legal structure usedfor business purposes, usually a corporation,

trust, or partnership, that either:

Does not have equity investors that havevoting rights and share in all profits and lossesof the entity.

Has equity investors that do not providesufficient financial resources to support theentitys activities.


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In a variable interest entity, specific

agreements may be limit the extent to whichthe equity investors, if any, share in theprofits or losses (etc.) of the entity.


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FIN 46 (an interpretation ofARB 51) uses the

term variable interest entity to encompassSPEs and other entities falling within itsconditions.

This pronouncement does not apply to

entities that are considered SPEs underFASB 140.


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Intercorporate Stockholdings

The common stock of the parent is held bythose outside the consolidated entity and is

properly viewed as the common stock of theentire entity.

In contrast, the common stock of thesubsidiary is held entirely within theconsolidated entity and is not stockoutstanding from a consolidated viewpoint.


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Because a company cannot report (in itsfinancial statements) an investment in itself,

the investment, as well as the equityunderlying that investment, is eliminated as

follows:

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Common Stock-Subsidiary BV *

Additional Paid-In Capital-Subsidiary BVRetained Earnings-Subsidiary BV

Investment in Common

Stock of Subsidiary BV* BV = Book Value

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NOTE: The equity accounts of the parentrepresent the equity accounts disclosed on

the financial statements of the consolidatedentity.

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Difference between Cost and Book

Value

The elimination entry related tointercorporate stockholdings (in theprevious slide) was prepared under theassumption that the parent purchased the

subsidiary at book value.

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Value

In reality, the purchase price of a subsidiaryusually differs from the book value of the

shares acquired. This differential is treated in the same way in

preparing consolidated financial statements

as for a merger, discussed in Chapter1.

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Value

Typical Situation: Generally speaking, if the

parent paid more for the subsidiary than bookvalue of the shares acquired (a net debitdifferential),

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Value

The excess would be allocated (during the

consolidation process) to specific assets andliabilities of the subsidiary, or to goodwill.

Allocation of differentials is extensively

discussed in Chapter4.

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Intercompany Receivables and

Payables

A single company cannot owe itself money,

that is, a company cannot report (in itsfinancial statements) a receivable to itselfand a payable to itself.

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Intercompany Receivables and

Payables Thus, with respect to the consolidated

balance sheet, the following entry is made to

eliminate intercompany receivables andpayables between the parent and thesubsidiary:

Consolidated Accounts Payable BV *Consolidated Accounts Receivable BV

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Intercompany Sales (Unrealized

Profits) A single company may not recognize a profit

and write up its inventory simply because the

inventory is transferred from one departmentor division to another (since no arms lengthtransaction has occurred to justify recognitionof the profit).

This also applies to intercompany saleswithin a consolidated entity.

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Intercompany Sales (Continued)

Since unrealized profits (in ending inventory)overstate ending inventory and understate

cost of goods sold, consolidated net incomeas well as consolidated retained earningsare overstated.

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Intercompany Sales (Continued)

With respect to the consolidated balancesheet, the following elimination entry is

required with respect to unrealized profitsin ending inventory (e.g., $2,000):

Consolidated Retained Earnings $2,000

Consolidated Ending Inventory $2,000

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Single-Entity Viewpoint

In understanding each of the adjustmentsneeded in preparing consolidated statements,the focus should be on both:

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Single-Entity Viewpoint

Identifying the treatment accorded a

particular item by each of the separatecompanies.

Identifying the amount that would appearin the financial statements with respectto that item if the consolidated entitywere actually a single company.

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Mechanics of the Consolidation

Process A worksheet is used to facilitate the process

of combining and adjusting the account

balances involved in a consolidation. While the parent company and the subsidiary

each maintain their own books, there are no

books for the consolidated entity.

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Process

Instead, the balances of the accounts are

taken at the end of each period from thebooks of the parent and the subsidiary andentered in the consolidation workpaper.

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Process Where the simple adding of the amounts from

the two companies leads to a consolidated

figure different from the amount that wouldappear if the two companies were actuallyone, the combined amount must be adjustedto the desired figure.

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Process

This is done through the preparation of

eliminating entries.

Consolidation workpapers and eliminatingentries are discussed in more detail in

Chapters 4 to 10.

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Noncontrolling Interest

For the parent to consolidate the subsidiary,only a controlling interest is needednot

100% interest. Those shareholders of the subsidiary other

than the parent are referred to as

noncontrolling or minority shareholders.

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The claim of these shareholders on theincome and net assets of the subsidiary is

referred to as the noncontrolling interest orthe minority interest.

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The FASB favors treating the noncontrollinginterest as an ownership interest, with the

noncontrolling interests claim on subsidiaryassets reported in consolidated stockholdersequity and the claim on subsidiary net incomereported as an allocation of consolidated netincome.

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The noncontrolling shareholders claim on the

net assets of the subsidiary is shown mostcommonly between liabilities andstockholders equity in the consolidated

balance sheet.

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Some companies show the noncontrolling

interest with liabilities although it clearly doesnot meet the legal or accounting definition ofa liability.

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The portion of the subsidiary net income

assigned to the noncontrolling interestnormally is deducted from earnings availableto all shareholders to arrive at consolidated

net income in the consolidated incomestatement.

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Although this assignment of income does not

meet the definition of an expense, it normallyis accorded this expense-type treatment.

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Combined Financial Statements

Financial statements sometimes are

prepared for a group of companies when noone company in the group owns a majority ofthe common stock of any other company in

the group.

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Combined Financial Statements

Financial statements that include a group of

related companies without including theparent company or other owner are referredto as combined financial statements.

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Different Approaches to

Consolidation

Several different theories exist that might

serve as a basis for preparing consolidatedfinancial statements.

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Consolidation

The choice of consolidation theory can have

a significant impact on the consolidatedfinancial statements in those cases where theparent company owns less than 100 percentof the subsidiarys common stock.

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Consolidation

The remaining slides focus on the following

alternative theories of consolidation:

Proprietary

Parent company Entity

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Proprietary Theory

The proprietary theory of accounting views

the firm as an extension of its owners.

The assets and liabilities of the firm areconsidered to be assets and liabilities of the

owners themselves.

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Proprietary Theory

Similarly, revenue of the firm is viewed as

increasing the wealth of the owners, whileexpenses decrease the wealth of the owners.

When applied to the preparation of

consolidated financial statements, theproprietary concept results in a pro rataconsolidation.

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Proprietary Theory

The parent company consolidates only its

proportionate share of the assets andliabilities of the subsidiary.

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Parent Company Theory

The parent company theory is perhaps better

suited to the modern corporation and thepreparation of consolidated financialstatements than is the proprietary approach.

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The parent company theory recognizes thatalthough the parent does not have direct

ownership of the assets or directresponsibility for the liabilities of thesubsidiary, it has the ability to exerciseeffective control over all of the subsidiarysassets and liabilities, not simply aproportionate share.

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Under parent company theory, separate

recognition is given in the consolidatedbalance sheet to the noncontrolling interestsclaim on the net assets of the subsidiary and

in the consolidated income statement to theearnings assigned to the noncontrollingshareholders.

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Entity Theory

As a general rule, the entity theory focuses

on the firm as a separate economic entity,rather than on the ownership rights of theshareholders of the parent or subsidiary.

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Entity Theory

Emphasis under the entity approach is on theconsolidated entity itself, with the controlling

and noncontrolling shareholders viewed astwo separate groups, each having an equityin the consolidated entity.

Neither of the two groups is emphasized over

the other or over the consolidated entity.

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Entity Theory

Because the parent and subsidiary togetherare viewed as a single entity (under the entity

approach), all the assets and liabilities of thesubsidiary and any goodwill are reflected inthe consolidated balance sheet at their fullvalues on the date of combination regardless

of the actual percentage of ownershipacquired.

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Entity Theory

Additionally, consolidated net income is acombined figure that is allocated between thecontrolling and noncontrolling ownershipgroups.


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Current Practice

The amount of subsidiary net assets

recognized in the consolidated balance sheetat acquisition is the same in practice as underthe parent company approach.

On the other hand, the determination ofconsolidated net income is a combination ofthe entity and parent company approaches.

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Future Practice

The FASB has proposed moving to an

entity approach in practice.

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Future Practice

This would result in classifying thenoncontrolling interest in the stockholders

equity section of the consolidated balancesheet and labeling the total income of theconsolidated entity as consolidated netincome, with an allocation of consolidated

net income between the controlling andnoncontrolling interests in the incomestatement.

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You Will Survive This Chapter !!!

Remember:

You cant own yourself. You cant owe yourself money.

You cant make money selling to yourself.

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You Will Survive This Chapter !!!

NOTE: Elimination entries tend to reduce

balancesnot increase them.

EXCEPTION: Entries relating to theallocation of the difference between

investment cost and book value, thatis, the differential.

3


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The Reporting Entity and Consolidated Financial Statements

End of Chapter

advanced financial accounting 7e (baker lembre king).chap003

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